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Brazil ETFs in Trouble?

It was believed by many that Brazil, Russia, India and China, collectively known as the BRIC nations would play a major role in global economic recovery. This conviction seems to have weakened with these countries buckling under economic pressure. Among the four countries, Brazil has become the weakest link with its equity market underperforming over the last two years.

This South American nation has suffered twin attacks from slower growth and heightened inflation. Some even fear that the country’s economy could be entering the stage of stagflation in the near term. Slower growth and higher inflation generally result in an strange situation in which measures adopted to tame inflation will halt growth and vice versa (Read: Time to Worry about Brazil ETFs?).

In fact, the International Monetary Fund cut its growth forecast for Brazil twice last year for both 2012 and 2013. Now, Brazil is expected to grow at 4.0% in 2013– a much lower rate than China, and a bit subdued from India’s growth projections.

The country has grown a meager 0.60% in the third quarter of 2012, while its inflation heated up. 2012 saw a 5.84% rise in inflation, higher than the year-ago level as well as the central bank’s target rate of 4.5%. Unfortunately, this was the third year that this top South American nation’s inflation came above the forecast.

However, on the rosier side, there is not that much tension looming on the unemployment front. The unemployment rate though high at 4.90% on a nominal basis in December 2012, was lower than the year-ago level of 5.30%.

Moreover, it was lower than two of its BRIC counterparts, India and Russia. But here also, wages are rising which combined with rising middle income is boosting consumer demand and in turn, inflation (see The Comprehensive Guide to Brazil ETFs).

However, in the near term, the country should see a surge in construction and general infrastructure spending, thanks to high profile events like the FIFA World Cup scheduled in 2014 and Olympics in 2016. These could act as a new stimulus program for the nation and help to pull it out of the current doldrums.

Although the biggest Brazil ETF– MSCI Brazil ETF (EWZ - Free Report) – with an asset base of $9.3 billion was down 3.5% in 2012, there are some funds that still attract investors. These include Market Vectors Brazil Small-Cap ETF (BRF - Free Report) which tracks Market Vectors Brazil Small-Cap Index and was up 14.8% in price terms in 2012 as well as iShares MSCI Brazil Small Cap Index (EWZS - Free Report) – up 28.44% last year.

While EWZ is highly concentrated in the large cap equities with the mining-giant Vale S.A. (VALE - Free Report) occupying the top position in the fund’s holdings, BRF and EWZS tap small ones (Read: Forget Petrobras with These Brazil ETFs). In terms of asset base, BRF currently holds around $586.4 million and EWZS carries about $58.0 million.

Historically it has been noticed that large caps tend to play with global markets while the small caps generally focus on the concerned country. This tendency sometimes misses out on any positive effect of the domestic economy and suffers if the global market is faltering.

On the other hand, amid a backdrop of slower growth rates in various emerging countries and lingering threats from debt-ridden Europe, investment in small caps can deliver above-market returns to investors demanding higher risk-tolerance.

A small scale of operation and weakness in terms of cash generation compared to the industry-giants compel these companies to remain regional and restrict them from being export-driven.

This could be part of the reason for the outperformance of BRF and EWZS as compared to EWZ. These two small-cap oriented funds are playing interestingly with the country’s relative strength while dodging the weaknesses that some of the large caps are seeing.

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